David Swensen managed Yale’s endowment for 35 years and transformed how institutions managed money. His Yale model took a simple idea and applied an unconventional approach to great success.
Swensen’s simple idea was that time horizon plays an important role in determining asset allocation. The time horizon for college endowments is basically endless. It allowed Swensen to tilt the portfolio to an equity-oriented allocation to take advantage of that extreme long-term view.
While a typical allocation holds a mix of traditional asset classes like U.S. and foreign stocks and bonds, Swensen shied away from that. Instead, his unconventional approach leaned heavily on what is now called alternative investments.
For example, in 2008, only 30% of Yale’s endowment was invested in traditional asset classes. 70% was in real assets, hedge funds, absolute return strategies, private equity, and venture capital. That asset mix allowed him to focus more on the least efficient markets. His goal was equity-like returns over long periods using uncorrelated assets. And it worked!
Swensen knew that every investor has three tools at their disposal to generate returns: asset allocation, market timing, and security selection. Research shows that market timing doesn’t work. In fact, it’s a net negative. It generates higher turnover, higher fees, and fails to do what’s intended. Returns tend to be worse when market timing is involved.
Security selection, like stock picking, requires a special skill set, a behavioral advantage, and inefficient markets. That makes it difficult for most people to beat the market. It also makes it difficult to find people who can. Higher fees only add to the difficulty. In essence, security selection detracts from returns.
While the endowment relies on actively managed funds, individual securities weren’t the priority. Not only was the endowment well diversified, but Swensen prioritized broad diversification within each asset class too. Security selection took a backseat to diversification.
If market timing and security selection are net negatives, then asset allocation drives returns. So Swensen built the best-performing college endowment on the foundation of two simple concepts: asset allocation and diversification. He created an asset allocation to grow Yale’s endowment for the long term and remained well-diversified to ensure that it survived extreme market events. Two concepts every investor can put to use.
Just to be clear. The average investor is not following the Yale model. Our time horizon is too short and most alternative investments are closed to us. But we can still learn from Swensen’s thought process behind managing Yale’s endowment.
On Worrying Top-Down
A guy named Seth Klarman, who works at a fund in Boston called Baupost, said that what he does is worries top-down and invests bottom-up. I read The Wall Street Journal every morning and I worry about the credit crisis, and I worry about credit cards, and I worry about auto loans, and I worry about corporate loans, and I worry about the solvency of the banking system, and then I go to work and I try and find the best opportunities that I possibly can. So, the worrying top-down helps because you don’t want to put yourself in a position where you’re going to get hurt by some adverse macro, sectoral circumstance.
On Beating the Market
You can divide institutional investors into two camps: those who can hire high-quality active-management investors and those who can’t… If you’re not going to put together a team that can make high-quality decisions, your best alternative is passive investing.
With a casual attempt to beat the market, you’re going to fail.
I think it’s logical that if you’re going to try and beat the markets, you’d want to beat the markets where the opportunity was greatest. Where’s the opportunity greatest? The opportunity’s greatest where assets are least efficiently priced.
On Complex Funds in Portfolios
One of the pieces of advice that I’ve had in my books, going back ten years now, is that investors in bonds should invest only in “full faith and credit” securities. Bonds that have call options or bonds that have credit risks or bonds that are highly structured, like the asset-backed securities and CDOs, just don’t belong in the portfolios of sensible investors.
On Asset Allocation
Studies show that asset allocation is responsible for more than 100 percent of the positive returns generated by investors… It’s because the other two factors, security selection and market timing, are a net negative.
The most sensible approach is to come up with specific asset allocation targets that you can implement with low-cost, passively managed index funds and rebalance regularly. You’ll end up beating the overwhelming majority of participants in the financial markets.
Anybody who thinks about investments in a common sense fashion knows that diversification is an important fundamental tenet of portfolio management.
An equity bias is an absolutely sensible underpinning for investors with long time horizons but…diversification is important. You have to limit your exposure to risky asset classes to a level that allows you to sustain those positions even in the face of terribly adverse market conditions.
You have to think about what’s going on in the tails of the distribution. I think that’s incredibly important… When you look at defining moments for portfolio management, they come in 1987, they come in 1998, they come in 2008-2009. And if you ignore that, you’re not going to be able to manage your portfolio effectively.
On Investor Mistakes
When you buy high and sell low it’s really hard to generate returns, even if you do it with great enthusiasm and great volume.
The underlying driving force behind market timing decisions seems to be emotional — fear, greed, chasing performance — buying something after it has gone up, disappointment, and sales after something has declined. As opposed to rationally stepping up when something appears relatively attractive and overweighting and then leaning against the wind by selling something that’s performed well.
This world of comparing returns to peers is all-pervasive. And I think it’s incredibly dysfunctional when it comes to making really good investment decisions.
I think one of the most pervasive problems in the financial markets is investment with too short a time horizon. The fact that people look at quarterly returns of mutual funds is incredibly dysfunctional… There just aren’t pricing anomalies that are significant that are going to resolve themselves in a matter of months or weeks and so it’s a silly game to play.
On Wall Street
Fund of funds are a cancer on the institutional-investor world. They facilitate the flow of ignorant capital. If an investor can’t make an intelligent decision about picking managers, how can he make an intelligent decision about picking a fund-of-funds manager who will be selecting hedge funds? There’s also more fees on top of existing fees.
When really smart, highly compensated, very clever people are on one side of the trade, and less highly compensated, less clever people are on the other side, you know who’s going to end up in the soup.
I think short-termism is incredibly damaging. There’s this focus on quarter-to-quarter earnings. There’s this focus on whether you’re a penny short or a penny above the estimate.
The mutual fund industry is not an investment management industry. It’s a marketing industry.
The investor is bombarded with staggering amounts of information, staggering amounts of stimuli that are designed to get the investor to buy and sell and trade, to do exactly the wrong thing, to create excessive profits for these intermediaries that aren’t acting in the investor’s best interests.
On the Yale Model
Yale will continue to hold a relatively well-diversified portfolio as defined by the range of asset classes in which it invests. When you look at each of those individual asset classes — domestic equities, foreign equities, bonds, real assets, absolute return and private equity — each of those individual asset classes is going to be relatively well-diversified in terms of exposures to individual positions or individual securities.
We just don’t take flyers on people that we think have interesting resumes… You want people of high integrity. You want people of unimpeachable character. You want people that are smart, incredibly hard-working. And in the investment world, you want somebody who’s really obsessed with the markets.
The type of manager we’re looking for is somebody who strives to generate excellent returns and they’ll frequently raise modest amounts of money and close to new investors, measuring their success by beating the market not by generating huge flows of fees for themselves.
I’m looking for somebody that’s got a screw loose and they define winning not by being as rich as they can be individually, but by producing great investment returns.
We require complete transparency. We either know every position, or we don’t invest. I have access to every position in every hedge fund in which we’re invested.
A lot of people look at Yale’s portfolio and say, oh it’s risky because you’ve got venture capital and you’ve got timber — we have all these things that you might believe are individually risky, but part of the magic of diversification is if you’ve got things that are individually risky but they’re not well correlated one to another, the overall portfolio risk level is quite low. I believe that we have quite a low risk portfolio.
If markets offer us opportunities, we’re more than happy to take advantage of them. So, we will make valuation bets. We’ll look at things — sectors — say they’re cheap or expensive and exploit the opportunity.
One of the most important metrics that we look at is the percentage of the portfolio that’s in what we call uncorrelated assets. And that’s a combination of absolute return, cash, and short-term bonds. And those are the assets that would protect the endowment in the event of a market crisis.
2008 Guest Lecture
Yale’s Investor Keeps Playbook
David Swensen’s Guide to Sleeping Soundly
A Conversation with David Swensen
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